Fearing the Fed not justified – FOMC statement already said all

Economic theory of the Chicago School states that participants in financial and commodity markets form rational expectations and thus, all information would be included in the prices. The developments in August demonstrated again that not all expectations and opinions voiced by traders and analysts are based on a rational analysis and information processing.

The US stock market reached an all-time high of the S&P 500 index following the FOMC meeting on July 31, 2013. But then the stock market for 2-1/2 weeks declined on fears the Fed could taper the bond purchasing program at the next FOMC meeting in September. Also the yield on 10yr US Treasury notes rose by almost 30 basis points in the same period and was only a whisker shy of the 2.90% mark.

But unlike in earlier situations, the fear in financial markets of the possibility the Fed might reduce the volume of bond buying played a role contributed to a recovery of precious metals prices. Quantitative easing is regarded as one reason for capital flows into emerging economies. With the fear the FOMC might decide to exit QE3 in September, international investors shifted funds from emerging economies back into Western economies. As a result, the US dollar weakened slightly against the major currencies as measured by the US dollar index.

The fears were driven to some extend also by comments from a few FOMC members. However, most of those members making statements about tapering opposed the program from the very beginning. But even more important, most critics of QE3 are non-voting members this year. Thus, many market participants expected more hints from the minutes of the recent FOMC meeting and at the same time feared the minutes would confirm the FOMC would decide to taper in September.

No doubt, minutes of a meeting could provide some further insights. Nevertheless, the FOMC statement already send the main message, namely that any decision to reduce the volume of bond purchases would be data dependent. And the economic data available at the FOMC meeting did not induce the committee to make a move towards tapering. Also data released after the July meeting does not provide a strong case for a decision to reduce the volume of bond purchases in September.

The minutes even provided arguments, which could reduce the likelihood for tapering at the next meeting. It has also been pointed out that tapering could increase the risk of moving towards deflation. This had also been discussed in this blog by turning the attention to the development of the core PCE deflator, which moved down towards the 1% level.

Unless there are shocks, there are normally no U-turns in the voting behavior of the FOMC members. This means that changes in monetary policy are indicated by an increasing number of members voting against the current stance of monetary policy instruments. However, the recent FOMC statement showed that one member voting against the majority at meetings earlier this year joint the majority at the July meeting and also voted for a continuation of the current policy.

Thus, the statement of the July FOMC meeting already provided enough hints that the minutes would not reveal new information, which would point to tapering in September. It could not be ruled out that the consensus of Wall Street economists might be right. However, the FOMC statement and the minutes as well as economic data released in August so far indicated that the odds are more for keeping the current volume of bond purchases of $85bn in total also at the September meeting.

At the US Treasury market, it should already be priced in that the FOMC will not continue to buy bonds at the current level forever. But given the moderate GDP growth and the low core PCE inflation far below the Fed target and that extremely accommodative monetary policy will keep the Fed Funds target rate at less than 0.25% well into 2015, the current yield level at the long end is attractive.